The Great Post-Pandemic Bank Failure.

Recent shutdown of the world's economy created immediate and dramatic economic impacts internationally. We are experiencing record unemployment, mass failure of small businesses, and financial strain in almost every aspect of our lives. Some economists predict that the United States is sinking into a deep and prolonged recession while others predict we will bounce right back. Are mare bank failures on the horizon? Possibly.

2008 vs. 2020

In 2008, banks lent money to home buyers and financed commercial real estate in record numbers to meet the demand for securities such as CDOs (collateralized debt obligations), RMBS (residential mortgage-backed securities), and CMBS (commercial mortgage-backed securities). Many banks combined and sold their mortgages to security firms when then sold them as securities; then the banks invested in those same securities. When the housing and commercial real estate markets took a hit, those banks were doubly affected because the loans they were producing went into default, and the corresponding securities drastically devalued. With the Lehman Brothers crash, the economy plunged; closing several "established" banks and loss of homes, properties, and wealth.

To prevent a repeat, Congress enacted the Dodd-Frank Act, which curtailed the amount of bank lending, limited high-risk bets the banks could take, and created more transparency of financial institution holdings. The Act empowered the Federal Reserve to "stress test," which is a forward-looking exercise that assesses the impact on capital levels that would result from immediate financial shocks and nine quarters of adverse economic conditions. Under the Act, credit-rating agencies were given new guidelines for rating the securities in light of the fact that thousands of securities rated AAA defaulted under the former standards.

Following these reforms, we enjoyed the longest bull market in history until the pandemic. Taking advantage of former schemes, banks shifted to similarly risky investments, like CLOs (collateralized loan obligation). The formula for CDOs and CLOs is similar. Instead of making loans to home buyers, the loans that are combined to make CLOs are made to troubled businesses. The security bundles together first-lien bank loans to businesses that are below investment grade. Similar to the CDO or RMBS/CMBS, the investment has multiple layers where investors can participate. The top layer has the least risk and the bottom is the riskiest. In order of preference, the top layer only loses money once the lower layers are wiped out.

In 2020, by most estimates, the CLO market ($880 billion) is bigger than the subprime-mortgage CDO market was at its peak ($640 billion). Easy mortgages of the 2000s fueled that decade's economic growth. Similarly, cheap corporate debt fueled economic growth this past decade, while companies have gorged themselves on the debt. Despite the obvious risks and similarity to CLOs, CDOs have been praised by the Federal Reserve and Treasury.

So Are We Faced With an Over-Leveraged Bank-demic?

Good news first. Since the last downturn, banks kept more capital on hand to protect against the failures of 2008. And not every bank is heavily invested in CLOs. You can check on your favorite bank by digging deep into the footnotes of its annual report. Typically, the number is listed as "available for sale" accounts, together with U.S. Treasury bonds, municipal bonds, etc. It's there that you will likely find the line item for "collateralized loan and other obligations" (e.g., CLOs). The size of the investment may be a surprise. The December 2019 report from the Financial Stability Board notes that for the 30 "global systemically important banks," the average exposure to leveraged loans and CLOs hovered around 60 percent of capital on hand. For more detailed information on this report, you can click the link above.

Time will tell if these investments pose banks the same destructive elements as their cousins in 2008. CLOs are marketed as safe investments, which is why they are listed along with U.S. Treasury bonds and municipal bonds in the bank's financial reports. Banks typically invest in the highest traunch of the CLO, insulating them to a degree since the lower tranches bear loss before the bank does.

As in the 2000s, credit rating agencies rate the top layer of the CLO as AAA-rated . You might be thinking, "wow, AAA-rating, the borrowers must be AAA-rated as well." Wrong. Fitch Ratings estimates that 67 percent of CLO borrowers have a B rating and 15 percent are rated lower still, at CCC or below. Remember that CLOs are made up of loans to businesses that are already in some financial trouble. B-rated borrowers are those who are likely to be unable to pay their debts in adverse economic conditions. Meaning, basically, under current circumstances these borrowers are unlikely to be able to pay their debts. Under the worst-case scenario, 82 percent (B-rated borrowers and below) will default and, the top 30 banks mentioned above would lose 60 percent of their capital on hand invested in the so-called AAA-rated layer of a CLO.

In fairness, so far, no AAA-rated layer of any CLO has ever lost principal and banks continue passing their "stress tests". For those of us keeping a close eye on this, however; there are a lot of similarities to the AAA-rated top layers of the CDOs banks booked in 2008 when we saw hundreds of banks close.

We remain hopeful that the economy will kick into gear once we are clear of the current pandemic and we are not facing an over-leveraged bank-demic. But we will likely see increased defaults through the summer as businesses start realizing losses from the pandemic shut down. The trend has begun for large companies in the hospitality, entertainment, and restaurant industries. There was also a large decline in the price of the AAA-rated CLO layers until the Federal Reserve announced it would include loans to CLOs, in addition to the $2.3 trillion of lending, much as it did in 2008 for CDOs.

Banks are not the only investors of CLOs. Insurance companies, like AIG, are also exposed. U.S. life insurance companies reported in 2018 that they held around one-fifth of their invested capital in CLOs. Pension funds, mutual funds, and exchange-traded funds are all also heavily invested in CLOs and other leveraged loans. With the 2008 downturn in mind, this all sounds very familiar and harkens of the days of the government bailout so well-received by the American people.

Conclusion

While banks have been more responsible since 2008 and it is unlikely that the issues outlined above will, by themselves, wipe out the capital reserves. It remains important to keep an eye on whether losses coming from CLO investments coupled with losses the banks could face from other troubled assets tip the scales. Absent caution, and a bit of luck, banks may be forced to liquidate assets in a down market to keep reserves up, causing the market to spiral yet again. If we dodge this bank-demic bullet, maybe it's time to seriously consider better ways to prevent banks, insurance companies, and pension funds from betting "the bank" on these risky investments disguised as high rated bonds.